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'Active Indexer' Sees Rougher Waters

Following up on his full report, the Active Indexer now finds reason to see the S&P 500 running into rougher waters in the short term.

(Editor's note: Below is an update to a full research report by the 'Active Indexer' found directly below this note.)

Yesterday, a long-time market watcher turned my attention to the likelihood that stocks will continue to crash all the way down to the 550 to 650 range for the S&P 500 Index.

If so, we talked about the likelihood that 50% of all hedge funds would close, which feeds more liquidations.

After this conversation, an associate sent me the attachment, which shows the S&P's multi-year double-top and double- bottom pattern with an ultimate low for the S&P near 550. This price is near long-term price trend line support for stocks.

Prior to this morning, my hope had been that the Oct 10 839 low would hold and that stock would rally, however, once this level of support fails there is not much support for S&P stocks until we get close to 770 (2002 low). If that fails, the next stop is near the 550 to 650 price level.

It is very likely that the S&P will test 750 today or Monday. My gut says we will see the 550 - 650 range.

A further crash enhances the odds of more financial firm failures and a huge derivatives accident.

The 2008 crash has been the third worst since 1929, in terms of degree of loss and speed of its price decline.

Here is commentary from Joe Conway of FTN Midwest Securities Corp:

"Make no mistake, we have been through a crash. While perception is that 1987 was a one day collapse, it was actually 11 trading days, dropping 39% (intraday peak of 10102/87 to 10/19/87 low). The current moMake no st recent drop was 14 days, dropping 32% (09/19/08 to 10110108). The intraday two day rally following '87 low was 28% (intraday) vs. the current of 25%. The '87 low was retested a week later and again a month later. It was "the low", but was retested twice. We would NOT chase here and fully expect some degree of retest where we can reevaluate.

Here are the stats surrounding the 1929 and 1987 market crashes (intraday high to low):

• 1929: Crash was 12 days and -36% and was followed by 2 day jump of 22%. The crash low was tested and broken 7 days later before a multi month bounce began.

• 1987: Crash was 11 days and -39% and was followed by 2 day jump of 28%. The crash low was tested a few days later and again in 6 weeks.

• 2008: Crash was 14 days and -32% and was followed by 2 day jump of 25%. What's next ????

Remember, these are intraday high and low numbers and certainly suggest at least a retest of the low.

(Editor's note: The following is the full research report following an "urgent update' presented by the author published by IU.com on Oct. 8, where he presented the possiblility that the S&P 500 would drop to around 800 or lower. See that research note here.)

The markets are in the process of liquidation with lower lows interceded by strong rallies. Listening to Mr. Market takes constant effort; sometimes he whispers his message from the distant past. Within hours after sending out an email to associates on October 6, 2008, at 9:20 a.m., I felt uneasy about my old target for a market low, which was first published on March 10, 2008 in Defend & Advance at www.indexuniverse.com. Back then, we identified a potential double bottom for the S&P 500 somewhere in the 972-1152 range, which was seen as likely because these prices represent average values that have supported stocks during most recessions since 1961 (Figure 1). We were expecting a recession in 2009 as a consequence of the debt crisis.

Figure 1. A Double Top & Double Bottom? Estimating The Downside I

My research on market history prior to World War II (Corporate Finance Review, Thompson Financial Services, 1997-2000), made me aware that since July 1997 (Asian Crisis), default risk has been more of a concern to markets than inflation risk. We will revisit this thesis in more detail at another time. For now, it is enough to say that my awareness of prior panics caused a swell of extreme discomfort in my target prices for market lows. It is time to question past assumptions and expand our views to market and economic conditions that existed all the way back to the panic of 1873, which was a time more like that of 2007-2008 than any other crisis period (more on this later; see http://www.itulip.com/ for 1873 comparisons).

After watching the market cascade down about 14% from October 1-7, I sat down with Mr. Market and listened to him tell tales about past bear markets. Lesson learned, I sent another email on October 08, 2008 at 8:37 a.m. with the following message:

"Last night, I viewed my charts relative to past periods of extreme and a protracted credit stress. This work shows that it is highly probable that companies will earn no better than $67 in 2009 for S&P 500 firms, which is 29% higher than current reported earnings near $52. Historically, P/Es near 12 are the median case. This setting is far from the worst case; even so, it means that the S&P will most likely correct down to about 800.

In a garden variety recession, my Feb 2008 forecast [above] showed support in the 972 to 1152 range, which provides room for a Double Bottom (1st Oct 2002) in inflation-adjusted terms near 960. S&P 950 is now viewed as temporary support with a Double Bottom being made in nominal terms matching that of Oct 2002 [below]. A case can also be made for a final low near 600. All indicators are pointing to a severe recession lasting many quarters.

We will use rallies to adjust hedges and portfolio exposures. Central banks will print a ton of money to lift credit markets, which eventually will cause higher inflation. They could combat deflation with an extreme monetized boost in money supply, which could stem equity declines in nominal but not in real terms. To avoid being hurt too badly in case they re-inflate, we will continue to build 10% positions in EWZ, GAF and MOO at lower prices. I expect the Central Bankers and G-7 nations to do something big soon."